Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 58
Chapter 2
ANSWERS TO QUESTIONS
1. If I can buy a car today for $5,000 and it is worth $10,000 in extra income to me next year
because it enables me to get a job as a traveling salesman, should I take out a loan from
Larry the Loan Shark at a 90% interest rate if no one else will give me a loan? Will I be
better or worse off as a result of taking out this loan? Can you make a case for legalizing
loan sharking?
Yes, I should take out the loan, because I will be better off as a result of doing so. My interest
2. Some economists suspect that one of the reasons economies in developing countries grow so
slowly is that they do not have well-developed financial markets. Does this argument make
sense?
3. Give at least three examples of a situation in which financial markets allow consumers to
better time their purchases.
Examples of how financial markets allow consumers to better time their purchases include:
x The purchase of a durable good, like a car or furniture.
4. If you suspect that a company will go bankrupt next year, which would you rather hold,
bonds issued by the company or equities issued by the company? Why?
5. Suppose that Toyota sells yen-denominated bonds in Tokyo. Is this debt instrument
considered a Eurobond? How would your answer change if the bond were sold in New York?
6. Describe who issues each of the following money market instruments:
a. Treasury bills
b. Certificates of deposit
c. Commercial paper
7. What is the difference between a mortgage and a mortgage-backed security?
Mortgages are loans to households or firms to purchase housing, land, or other real structures,
where the structure or land itself serves as collateral for the loans. Mortgage-backed securities
8. The U.S. economy borrowed heavily from the British in the nineteenth century to build a
railroad system. Why did this make both countries better off?
9. A significant number of European banks held large amounts of assets as mortgage-backed
securities derived from the U.S. housing market, which crashed after 2006. How does this
demonstrate both a benefit and a cost to the internationalization of financial markets?
The international trade of mortgage-backed securities is generally beneficial in that the European
10. How does risk-sharing benefit both financial intermediaries and private investors?
11. How can the adverse selection problem explain why you are more likely to make a loan to a
family member than to a stranger?
12. One of the factors contributing to the financial crisis of 2007–2009 was the widespread
issuance of subprime mortgages. How does this demonstrate adverse selection?
13. Why do loan sharks worry less about moral hazard in connection with their borrowers than
some other lenders do?
14. If you are an employer, what kinds of moral hazard problems might you worry about with
regard to your employees?
15. If there were no asymmetry in the information that a borrower and a lender had, could a
moral hazard problem still exist?
16. “In a world without information costs and transaction costs, financial intermediaries would
not exist.” Is this statement true, false, or uncertain? Explain your answer.
17. Why might you be willing to make a loan to your neighbor by putting funds in a savings
account earning a 5% interest rate at the bank and having the bank lend her the funds at a
10% interest rate, rather than lend her the funds yourself?
18. How do conflicts of interest make the asymmetric information problem worse?
Potentially competing interests may lead an individual or firm to conceal information or
disseminate misleading information. A substantial reduction in the quality of information in
19. How can the provision of several types of financial services by one firm be both beneficial
and problematic?
20. If you were going to get a loan to purchase a new car, which financial intermediary would
you use: a credit union, a pension fund, or an investment bank?
21. Why would a life insurance company be concerned about the financial stability of major
corporations or the health of the housing market?
22. In 2008, as a financial crisis began to unfold in the United States, the FDIC raised the limit
on insured losses to bank depositors from $100,000 per account to $250,000 per account.
How would this help stabilize the financial system?
During the financial panic, regulators were concerned that depositors worried their banks
23. Financial regulation is similar, but not exactly the same, in industrialized countries. Discuss
why it might be desirable—or undesirable—to have the same financial regulation across
industrialized countries.
This is a topic for which there is no clear answer. On one side, it would be beneficial to have
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 63
ANSWERS TO APPLIED PROBLEMS
24. Suppose you have just inherited $10,000 and are considering the following options for
investing the money to maximize your return:
Option 1: Put the money in an interest-bearing checking account that earns 2%. The FDIC
insures the account against bank failure.
Option 4: Hold the money in cash and earn zero return.
a. If you are risk-neutral (i.e., neither seek out nor shy away from risk), which of the four
options should you choose to maximize your expected return? (Hint: To calculate the
expected return of an outcome, multiply the probability that an event will occur by the
outcome of that event.)
b. Suppose Option 3 and Option 4 are your only choices. If you could pay your friend $100
to find out extra information about Mike that would indicate with certainty whether he
will leave town without paying, would you pay the $100? What does this say about the
value of better information regarding risk?
a. With Option 1, since deposits are insured it can be assumed a riskless investment.
Thus, the expected total payoff would be $10,000 × 1.02 = $10,200. With Option 2, a
b. Option 3 implies the very real possibility of either receiving nothing (if he actually
leaves town), or $10,800 (if he indeed pays as promised). If you don’t pay Mike, you
Mishkin • Instructor’s Manual for The Economics of Money, Banking, and Financial Markets, Twelfth Edition 64
ANSWERS TO DATA ANALYSIS PROBLEMS
1. Go to the St. Louis Federal Reserve FRED database and find data on federal debt held by the
Federal Reserve (FDHBFRBN), by private investors (FDHBPIN), and by international and
See table. Since the year 2000, the Fed has increased its share of federal debt held, and
foreign investors have significantly increased its share of debt held. This reflects a significant
decline in the share of federal debt held by private investors.
2017:Q1 2000:Q1
Held ($bil.) % Share Held ($bil.) % Share
Fed 2859.1 13.7 501.7 10.5
2. Go to the St. Louis Federal Reserve FRED database and find data on the total assets of all
commercial banks (TLAACBM027SBOG) and the total assets of money market mutual funds
(MMMFFAQ027S). Transform the commercial bank assets series to quarterly by adjusting
the Frequency setting to “Quarterly.” Calculate the percent increase in growth of assets for
each series, from January 2000 to the most recent quarter available. Which of the two
financial intermediaries has experienced the most growth?
commercial banks during that time, at 57.1%.
2017:Q1 2000:Q1
Commercial Banks $16,158.7 Bil. $5,639.9 Bil.